Why are stablecoins important?
A stablecoin is a digital asset or cryptocurrency that is pegged to fiat currency or other financial assets. Initially created to solve the volatility issues of cryptocurrencies, stablecoins have evolved to provide more utility.
In this article, we look at how stablecoins work and why they are essential to the new digital economy.
There are several types of stablecoins, including fiat-backed, crypto-collateralized, and algorithmically stabilized stablecoins.
A Fiat-collateralized stablecoin is a cryptocurrency that is backed by a traditional currency like the United States Dollar (USD), Euro (EUR), British Pound (GBP), and Nigerian Naira (NGN). For example, a stablecoin pegged to the dollar is issued at a 1:1 ratio backed to assets stored in a bank.
Tether USD, USD Coin, True USD, and Paxos Standard Token (PAX) are examples of fiat-collateralized stablecoins. This type of stablecoin is the most popular as it regularly used on exchanges instead of traditional currencies.
On the other hand, crypto-collateralized stablecoins, run similarly as their fiat counterparts except that, they are backed by cryptocurrencies instead.
Cryptocurrencies as collateral is a more decentralized alternative to fiat-backed stablecoins since all transactions remain on the blockchain.
However, these stablecoins have to maintain stability amidst the volatile cryptocurrency market. An example of crypto-collateralized is the Maker DAO (DAI).
Maker DAO (DAI) solves the collateral stability issue by over-collateralizing each coin. This means that for every dollar of the stablecoin, there is over a dollar of cryptocurrency in reserve depending on the level of volatility.
Other examples of crypto-collateralized are Synthetix and Staticoin.
Finally, algorithmically stabilized coins are based on algorithm balancing a circulating supply of stablecoins. In short, more coins are issued when the price of the asset rises, and the quantity is reduced when the price falls.
These various stablecoin types have increased in usage over the years. Here are some of the biggest use cases of stablecoins:
Cryptocurrency Trading
Stablecoins provide an excellent method to park money during trading, or to use as a base currency. The most prominent use case of stablecoins is stability and how it helps cryptocurrency users, especially traders, to hedge against volatility.
This stability allows cryptocurrency traders to move funds frequently, in and out of exchanges at low costs. Also, traders who anticipate volatile price action can exchange their other cryptocurrencies to stablecoins to maintain value.
Traders can seamlessly transfer funds to their bank accounts using stablecoins. For instance, the USD Coin platform has a “redeem feature” that allows you to connect to any bank account of your choice to receive your US Dollar.
Digital Payments
Stablecoins are also crucial for making digital payments. Cryptocurrency payments have been dropped by some companies who adopted it due to volatility.
For instance, an invoice worth $100 for domain hosting paid in bitcoin could be worth far less in a few hours if the bitcoin price falls.
In such situations, companies may lose money. To circumvent this, companies can accept stablecoins or accept other cryptocurrencies and have it converted to stablecoins immediately.
In addition, stablecoins can be used for remittances. Stablecoins present a quick and affordable way for people to send money around the world.
This use case is expected to be more relevant in developing markets like Africa and South America.
Earn Money From Stablecoins
Just like every other cryptocurrency that allows users to make money usually via mining or staking, some stablecoins allow you to make an income through its creation or stabilization.
For instance, holding Maker DAO’s DAI token allows you to earn passive income. The Maker community sets the DAI Savings Rate, which is an interest rate paid to holders of DAI from the stability rate paid by users who borrow DAI.
The Bitshares blockchain is also popular for the creation of stablecoins like BitUSD which allows you to stake BTS, the native currency of the platform. You then receive rewards for staking BTS.
More stablecoins are set to be created in efforts to digitize most traditional currencies and financial assets alongside new use cases like stablecoin lending. AAX is always in tune with the latest developments in the ecosystem.
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Originally published at https://academy.aax.com on February 25, 2020.
